May 9, 2022
Joe Fairless

JF2806: When Active Investors Should Start to Invest Passively | Round Table


Welcome to the first Best Ever Round Table, where the three Best Ever Show hosts come together for a deep dive into a commercial real estate investing topic. In this episode, Ash Patel, Slocomb Reed, and Travis Watts discuss when they think active investors should consider passively investing. Here are some of their responses:

 

As soon as you have the means. 

“Everyone with the means should be exposing themselves to passive investing. Getting involved in a passive investment when you know that you can trust the operator or the active partner is going to reveal to you a world that you may not have previously realized exists.

When asked how he got started passively investing, Travis Watts explains that he was putting a lot of time and energy into doing active deals, and he was looking at projected returns that were at or above what he was currently getting. When he learned about passive investing, he was skeptical, but after finding mentors he trusted, he gained the confidence to start doing deals. 

 

If it fits into your tax strategy.

Ash Patel discusses the negative K-1s that come from passively investing in real estate while these deals are in operation, which can greatly impact your personal taxes. “The negative K-1s that you get from being a passive investor in assets like multifamily and hotels are tremendous and rarely get talked about,” he says. After his first year of passively investing, Ash was thrilled with the negative K-1s he received, which helped him to offset other income. 

 

If you want to work smarter, not harder. 

Travis encourages active investors to compare passive investing in real estate with the other passive investment vehicles that are available to them. For example, while he follows the FIRE movement (Financial Independence Retire Early), he dislikes that it’s mostly stock-focused, following the 4% rule. 

“You live off the 4% rule, which means you’re selling off, you’re kind of eating away at your nest egg every year, 4% of the account value, and then you’re using it to live on,” Travis explains. “The problem with that is, one, you’re eating away at the nest egg. Two, it’s often pretty equity heavy.” 

Through passively investing in real estate, he’s switched that 4% rule to 8% cash flow passive income in order to avoid eating away at his principle. “I’ve got double that kind of yield, and I still have equity upside that can be turned over into more deals,” he says.

 

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TRANSCRIPT

Slocomb Reed: Best Ever listeners, welcome to the Round Table. I'm Slocomb Reed, and today I'm with Ash Patel and Travis Watts. The hosts of The Best Ever Show come together every week for a deep dive into a commercial real estate investing topic. Today, our topic is when active investors should start to invest passively. Let's dive in.

I want to start by asking Ash. I know you were an active investor well before you started investing passively. When in your investing career did you decide it was the right time to be a passive investor and why?

Ash Patel: Yeah, great question, Slocomb. I started in 2015, so five years into my real estate investing career. And I started passively investing because it was the first time I heard of it. Joe Fairless and I went out to lunch, and I didn't know who he was before he interviewed me for his podcast. The back-story on that is he just found me on BiggerPockets, found out that I was a local guy in Cincinnati, and asked if he can interview me for his podcast. Sure, we decided to do lunch afterwards. I'm like, "What do you do?" Who would have thought you asked Joe Fairless what do you do? Nonetheless, I found out that he does syndications, and he actually had a deal that was open to investors at the time. The returns at the time were like 23%, is what they were claiming. Now, that deal ended up returning 26% plus. Nonetheless, I put money into his deal. I committed X number of dollars to the deal. I got home and I'm like, "Wait a minute, this is too good to be true. I literally put money in there, and I get returns every quarter at the time, and then I double my money in five years? Like, this is crazy." I thought it was too good to be true but if I lost the money, lesson learned, and I've since done probably a dozen deals with him thereafter.

Slocomb Reed: So the catalyst for you investing passively was learning that passive investing is a thing.

Ash Patel: 100%.

Slocomb Reed: And of course, you learned that from Joe Fairless, and we know how reputable, high integrity, and high performance his deals have been, so it's a great place to start, of course. Travis, what about you? I know you were doing some active investing early on. When did it make sense for you to transition to more passive investing and why did you make that switch?

Travis Watts: Sure, I'll dive into that. But first of all, this is awesome that we're doing this because we all know each other, but to dive deep into all these different topics... There are so many parallels, Ash, to your story and mine. The timeframe was nearly the same. I did active real estate for about six and a half years. I was starting at the tail end of 2009, doing fix and flips, which was not a great thing... Then I got into some vacation rentals, and house-hacking, and I had some buy-and-holds... I was doing everything on my own, to your point, because I didn't realize there was an alternative.

If someone had told me in 2009, real estate investor, the only thing I could comprehend was to buy a single-family home and do something with it, flip it or rent it. That was the only thing. So years went by, I was working a W2 job, 98 hours per week. It was 14 hours per day, seven days a week, it was in the oil industry... And one, I hated that career, but two, I was trying to do all of this real estate on the side, trying to scale that up, so you can imagine what a recipe for disaster that was.

2015 was my year as well to discover this stuff. I think for anyone that was involved around that time and you look back, you see how much it's really blown up and expanded since then, with the conferences and the podcasting. It's like everyone's doing it now. Maybe my bias too, just being fully focused on it.

But anyway, the reason I did it, Slocomb, is because - similar to Ash's story - I was doing some of these active deals, putting a ton of time and effort and energy into them. I wasn't very good at what I was doing, quite frankly, and I'm looking at projected returns that are at or above what I was getting myself. So a little skeptical, but I thought, if this is true, then that's a game-changer, to be a hands-off real estate investor. That's really something cool.

So I found a couple of mentors, long story short... They had been full-time LPs for like 20 plus years and different deals. That's where it became real for me, I thought, "Okay, I trust these people." They were local to me, in my city and started doing deals in 2015.

Slocomb Reed: That's awesome. I bought my first active investment just over eight years ago. You guys got into passive investing faster than I did. But if I have to be the slow guy out of the group, I want it to be the group of The Best Ever Podcast hosts. I guess that's still a pretty good group to be the slow guy in. Not necessarily asking you personally, but I know that each of you gives advice to other investors, not necessarily directly about deals, but what they should and shouldn't be doing with asset classes and investing styles. For someone who has come up through the single-family, small multifamily, or small retail grind, and had some success over the last five, six, seven, eight years, looking back on your own experience, and thinking about the people you know who are making that same transition or looking to make that same transition, what advice do you give to people like me and our Best Ever listeners about when they need to start considering investing passively? Let's start with Ash.

Ash Patel: Yeah, good question. The negative K1s that you get from being a passive investor in assets like multifamily and hotels are tremendous and rarely talked about. I couldn't believe it when I got the first year's tax returns, the negative K1s from Ashcroft was tremendous. I mean, I was able to offset a lot of other income based on that negative K1. I think that's an important thing that people have to look at in their overall financial plan, is when you invest passively with somebody, those negative returns are huge. So you're making money tax-free, and also, if you're a real estate professional, you're able to offset other income that you have. You've got to keep that in mind.

I think it's a mindset issue also, where if you start that real estate journey, you're thinking, "Okay, at some point, I'm going to be able to quit my W2. At some point, I'm going to make it. At some point..." And you never really bring in the thought of passively investing. So it's getting out of your own way as well, doing some numbers. If I have some passive investments, some active, how will my portfolio look in three or five years?

Travis Watts: 100%. I'm going to dive in there on a couple of topics that you brought up. One, I never got into this for the taxes. But to your point, incredible. The more you learn, the more it's evolved into that, and it's more of a tax strategy at this point. Of course, we all love making money too, but yeah, it's rarely talked about. I've done a few episodes on that myself. But let's dive into the numbers, because I think this is pretty interesting. I'll start with the macro-level.

I'm a full-time passive investor. I don't advocate everyone should do that or become that, that's not for everyone. If that fits your mold, that's awesome. But most people are a hybrid mix. They're doing some things actively and some things passively. But the facts are that social security is getting cut, pensions are going away, and people are having to rely on themselves to get to retirement, if you're ever going to get to retirement.

So I'm an advocate for everybody considering an element of passive income. It can be from multifamily, it can be from single-family, it can be from publicly-traded REITs, or note lending, or ATM machines, or whatever. I'm unbiased, so to speak, in that category, I'm just a fan of people building up the income streams. You never know what's around the corner; you get injured at work, you get laid off because of a pandemic or something... It certainly wouldn't hurt to have a few thousand a month rolling in to help cover the bills. I'm a fan of people at least getting to that stage, a little bit of financial security... But ideally, financial freedom or financial independence.

The numbers I want to put to it that I've used for myself, this is not financial advice or recommendation for anybody. It's just what I've done. Since 2015 is I've lived on approximately an 8% cash flow yield, coming from all different sources, to replace my W2 income. So the numbers would go like this, you have to decide for yourself how much is enough, or how much you want your goal to be initially.

We'll use some simple math, $100,000 a year. Well, you would need 1.25 million invested at 8% a year to give you $100,000. So you just start with that. Now, you may not agree with 8%. You might say, "How about 6%? Well, 1.67 million?" Okay, how about 10%? 1 million." You've just got to run the math, to Ash's point, and figure out what makes sense for you.

The equity, as Ash mentioned earlier on some of these deals - I just let it roll over and compound, but I'm living on the cash flow yield. So that's how I invest, kind of how I see it, and why I make the case that everybody, whether you're an active syndicator or a GP, a doctor, a dentist, a lawyer, attorney, a CEO, a VP, an engineer - everyone should be thinking about some form of passive income to help you out in one way or another down the road.

Slocomb Reed: Travis, following up on that, within the FI community, the idea of a freedom number is very common. Or the amount of equity, or liquid or investable capital that you need to have to be able to retire and live off of the cash flow yield of that much... When you're talking to people about becoming a passive investor, are you typically recommending that they have some percentage of that "freedom number" in place already? Or is it as soon as you can dip your toe in, get a couple of passive investments and have that experience?

Travis Watts: Yeah. Well, a couple of things on that. One, just to use a real-life example, I've helped my nephews that are between ages 19 and 16 at this point, open brokerage accounts... Because I understand they're not starting out with 100k to invest, things like that, they're starting out with a few hundred dollars to invest. So I'm showing them in the publicly-traded world that there are vehicles, that there are ticker symbols, and there are REITs that you can invest in that pay a monthly distribution and a cash flow yield or a dividend yield. So you could start -- I'm helping them with the mindset side of it... Start as low as a couple 100 bucks doing that.

But if you've got more capital to deploy, and especially if you're an accredited investor, the world is your oyster. To elaborate on the FI community, as you mentioned, I've followed loosely the FIRE movement, financial independence, retire early. Where I differ from that is that it's mostly stock-focused. A lot of folks will say, the old Wall Street advice - you have a million dollars in your IRA or a brokerage account, or whatever it is in stocks, you live off the 4% rule. This means you're selling off, you're eating away at your nest egg every year, 4% of the account value, and then you're using it to live on.

The problem with that is, one, you're eating away at the nest egg. Two, a million bucks, 4%, 40k - it's often pretty equity-heavy. So I've switched it to more of the 8% cash flow passive income thing, where I'm not eating away at my principal, I've got double that kind of yield, and I still have equity upside that can be turned over into more deals. So that's the pivot that I made in it. But overall, I'm a big fan of the FI community, designing and knowing your own numbers and what makes sense for you.

Slocomb Reed: Awesome.

Ash Patel: Let me add something to that, if I may.

Slocomb Reed: Go for it, please do.

Ash Patel: Travis, a lot of good points there... And I want to share a quick story. We were at a retirement party for a friend of ours who was a doctor. He pulled me aside and he's like, "Ash, you're in real estate, right?" "Yeah." "Alright. So from time to time, you may need investment dollars to take down deals?" I said, "No, not really, but tell me more." At the time, I didn't want other people's money. But he's like, "Yeah, I'd love to get a return on some capital." I said, "What are you looking for?" This was maybe 2019, and he said, "Probably 6% or 7% would be great." I'm like, "Really? I don't touch a deal unless it's 20% or higher." He's like, "Oh, no, no, that's too high. It's too high."

People don't know that even the 8% pref exists. I've interviewed so many financial people who have turned into real estate investors, and I always ask them, "Why was it that when you were in the finance industry, managing other people's money, why didn't you ever recommend real estate investments?" And I get a couple of different answers, but at the end of the day, when I poke and prod, the answer is always, "Because there was no way for us to get kickbacks or commission on real estate investments."

I didn't know about passive investments before 2015. So there's a whole world of people out there that don't know that this exists, they all have their finance guy. "How's your finance guy doing?" "Yeah, I think he's doing pretty well." A lot of people don't have the time or the knowledge to manage their own money, and I think if they knew that vehicles like this existed out there, we'd have a lot bigger pool of investors.

Travis Watts: 100%, couldn't agree more. I think it has a lot to do with marketing too, and how we're all brought up. When was the last time you're driving down the highway and there's a billboard that says, "Here's a syndication deal, want to invest?" It's always Fidelity, Schwab, Janus, and TD Ameritrade. So to your point, it's all about stocks, bonds, and mutual funds. In the world of yield, for the most part, coming from buying an index fund, buying a US Treasury bond, buying corporate bonds, buying an annuity, putting your money in the bank, or doing a CD - this is what most people get exposure and marketing to at 1%, 2%, and 3% a year kinds of yields.

So when we're all on a podcast like this, talking about something doing 20% or you don't touch a deal unless it's 20%, a lot of people get freaked out. A lot of people immediately think, "Scam, Ponzi thing. I want nothing to do with this. I don't even know what you're talking about." So that's the barrier we're trying to take down, but those are great points, Ash.

Ash Patel: Yeah, it's the exact same thing I felt when Joe pitched that deal to me.

Travis Watts: Yeah, and I did, too. I was skeptical, quite frankly, mostly because I was doing all the work and getting the same outcome.

Break: [00:17:00.28] - [00:18:49.02]

Slocomb Reed: I can already think of some people that I want to hear this conversation when it airs. Thank you, guys. I do have a question... Keeping the perspective of someone who has been an active investor who is going passive, and is now looking at being the passive investor in a deal, everything that we're talking about right now is about being an equity investor. Have you decided on deals in the past that it was better to be a debt investor? Or have you ever invested in an opportunity to be a debt investor, where you were effectively holding a note on someone's deal instead of holding equity?

Ash Patel: I have not. I think the problem with a lot of us real estate guys is that we know how to grow money at a much higher rate than typical debt returns.

Travis Watts: That's a great point. An alternative perspective for me is -- well, the short answer is I actually have. And some of the reasons I did that - it gets back to my 8% rule, so to speak, for myself. If I'm entering a new deal today that may be slightly under that, let's say in year one, it might only cashflow six or seven... I might be more enticed to do some hard money lending at say 12%, so that I can average out the cash flow that's in the portfolio. But I usually only do that if it's a portion of my portfolio I'm actually using to live on as current income. I wouldn't do that if I didn't need the money, if I had the choice - a 10% debt fund, a potential of 20% to 30% through a syndication... I'd be more inclined to do the syndication and the equity, to Ash's point. So a little bit of both there.

It's different for different people. My dad, for example, he's turning 70 this year, and he lives on his fixed-income investments, so he's a fan of these A-shares; if anyone's ever looked at an Ashcroft deal, they have like A and B class shares and so it's just really a cash flow play with no equity upside potential. He does some of that stuff, because he's more enticed and more inclined to go for current income, and not five, 10 years down the road, in his scenario.

Slocomb Reed: Speaking to that point, Travis, with deals like the ones you're discussing, where A-shares have a higher preferred return, but B-shares with a lower preferred return participate in the upside upon the sale of the deal... When is it that you two, Travis and Ash, recommended that someone take one over the other? Or really, I think the question is, when would you recommend that someone take class A shares with a higher pref, but a lower return over the life of the deal?

Travis Watts: Ash, do you want to take that first?

Ash Patel: Yeah, I think Travis's previous answer hit it perfectly. When you can no longer afford the risk, or you no longer want the risk.

Travis Watts: Right. The other scenario I see - this is coming from, working in investor relations for a number of years - is sometimes we'll have what's called a fund of funds invest. So it's someone else's family office fund or whatever kind of fund it is... And in their portfolio, they're usually lacking cash flow, or dividends, or interest, or whatever you want to call passive income. It's more equity-focused. They might do a tranche of their fund in the A-shares to boost the cash flow, so that they can create more of a hybrid mix of passive income and equity. That's another scenario, other than folks living on fixed income basically, needing the monthly distributions.

Slocomb Reed: Gotcha. Well, with the original question being, "When do you get into passive investing when you're already an active investor?", a few key points that I've pulled out of the answers that you too have given - and please expound on them or correct me where I'm wrong... The first thing I heard both of you touch on is that everyone with the means should be exposing themselves to passive investing. Getting involved in a passive investment when you know that you can trust the operator, or the active partner, is going to reveal to you a world that you may not realize exists, or you may not realize how sweet it is.

Ash brought up the point of the negative K1 that comes from these deals while they're in operation and the impact that can have on your personal taxes. A point that Travis brought up was also thinking about passive investing in real estate by comparison to the other passive investing vehicles that you have available to you outside of real estate, when you recognize -- if you're thinking like the FIRE community with that 4% rule, you just have to build a much larger nest egg than you do as a passive investor in the vast majority of real estate syndications. What other key points do you think there are here that people need to consider?

Ash Patel: Thanks, Slocomb, real quick... Just so our Best Ever listeners and myself know what FIRE means? What is it? Is that financial independence, retire early?

Slocomb Reed: Yes. A lot of people call it the FIRE community, and Travis was speaking about the fire community and some of their key principles on personal finance earlier on in the show.

Ash Patel: Alright. Thanks for clearing that up. So I think it's really important that you have one metric - and this is my opinion... Your one metric should be cash on cash returns; annualized cash on cash return. And then add to that the taxable consequence of that return. So if at the end of the year your investment returns 20%, but it's a short-term gain, you're paying the full tax on it, you have to look at what your net gain is. If at the end of the year, your investment return is 20% and it's a long-term capital gain, you have to take that into consideration as well. But for every investment, whether I invest in a business, a startup, real estate, or my own deals, I always look at the annualized cash on cash return with the tax implication, because we all have a finite amount of cash. At some point, we run out; so you have to make sure you maximize the return on your cash to meet your goals. That's my metric for everything.

Slocomb Reed: And you're not including the sale of an asset... When the business plan dictates the sale of an asset, you're not including that in your cash-on-cash number?

Ash Patel: I do. If it's an 8% pref, 20% IRR, I will take the 20%... But it really gets thrown onto your balance sheet upon sale. But it's an anticipated return, which is important.

Travis Watts: That's a great point. I'm going to end this with a story real quick, a true story of one of my mentors a long time ago. A very wealthy individual who sold his company in the mid-90s. It took a while for me to get up to this point of asking him this, but I was getting into the allocation of his investment portfolio, where he's putting the bulk of his money or how he diversifies, or does he diversify... And I remember him saying, "I have 40% of my entire portfolio in insured muni bonds that are tax-free." And I thought, "You are crazy, man. You are insane." Those things do like 2% or 3%, whatever. I failed to realize that if you look at how much he actually had in capital - he's got at least a million dollars a year coming in completely tax-free from that investment. His philosophy is that it's his safety net. If the whole world goes to crap, if all his other investments failed on him, he still has a million dollars a year tax-free, to your point, Ash. You may or may not agree with how he's done it, but he's got a point, and you do have to pay attention to taxes if you're a high-income earner, paying 50%+ in tax out in California or something. It matters a lot right; your yield is just cut in half.

Slocomb Reed: Both excellent points. Ash, Travis, thank you. Best Ever listeners, thank you as well. If you've gained value from this episode, please do subscribe, leave us a five-star review, and share this episode with a friend who you think needs to hear the advice that Ash and Travis have given us today. Thank you and have a Best Ever day.

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